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Wednesday, November 20, 2013

A Tripartite Mandate for Central Banks?

The U.S. Federal Reserve operates under what is commonly called a "dual mandate," which basically means that it should take both inflation and unemployment into account when making its decisions. The dual mandate means that the Fed does not take into account the risk that asset market bubbles are destabilizing the economy. Should the dual mandate be turned into a tripartite mandate, with the risk of a financial crisis as the third factor that the Fed (and other central banks) should also take into account. In the most recent issue of the Journal of Economic Perspectives, Ricardo Reis discusses "Central Bank Design," and in particular what the economics literature has to say about a range of issues related to how central banks should choose their goals, their decision-makers, their policy tools, their communication methods, and more. Reis explains why economists have typically not supported a treble mandate in the past, and also why he thinks that this may change in the not-too-distant future.

Why have central banks typically not focused on asset market bubbles and financial instability in the past? Here's how Reis explains it (as usual, citations and footnotes are omitted):

"A more contentious debate is whether to have a tripartite mandate that also includes financial stability. After all, the two largest US recessions in the last century—the Great Depression of the 1930s and the Great Recession that started in 2007—were associated with financial crises. ... [I]f financial stability is to be included as a separate goal for the central bank, it must pass certain tests: 1) there must be a measurable definition of financial stability, 2) there has to be a convincing case that monetary policy can achieve the target of bringing about a more stable financial system, and 3) financial stability must pose a trade-off with the other two goals, creating situations whereprices and activity are stable but financial instability justifies a change in policy ... Older approaches to this question did not fulfill these three criteria, and thus did not justify treating financial stability as a separate criterion for monetary policy."

As a recent example, think back to the dot-com bubble of the late 1990s. Sure, the price tech stocks seemed to be soaring implausibly high. But was it really the role of the Federal Reserve to decide that stock prices were "too high," and to change monetary policy, perhaps bringing on a recession, in an effort to bring stock prices down? As Reis notes: "Yet, at most dates, there seems to be someone crying “bubble” at one financial market or another, and the central bank does not seem particularly well equipped to either spot the fires in specific asset markets, nor to steer equity
prices."

When the dot-com boom was followed by a short and shallow recession in 2001, the Federal Reserve did what it could to cushion the economy with lower interest rates at that time. I'm probably not alone in being someone who watched the housing price boom around 2006 and thought: "Sure, there might be a recession eventually, like in 2001, but it works OK to have the Federal Reserve react after the fact when unemployment goes up. The Fed isn't well-equipped to judge when housing prices or stock prices are "too high" or "too low," nor to adjust monetary policy to alter such prices.

But as Reis points out, more sophisticated ideas of how to define the rising risk of a financial crisis have come into prominence in the last few years. Instead of focusing on whether stock prices or house prices are rising, or seem "too high," these approaches look at factors like whether total borrowing is rising. Reis explains:

"A more promising modern approach begins with thinking about how to define financial stability: for example, in terms of the build-up of leverage, or the spread between certain key borrowing and lending rates, or the fragility of the funding of financial intermediaries. This literature has also started gathering evidence that when the central bank changes interest rates, reserves, or the assets it buys, it can have a significant effect on the composition of the balance sheets of financial intermediaries as well as on the risks that they choose to take. ... While it is not quite there yet, this modern approach to financial stability promises to be able to deliver a concrete recommendation for a third mandate for monetary policy that can be quantified and implemented."

A final point here is that implementing a tripartite mandate may also mean changing how one describes the policy tools of a central bank does in a different way. Up to 2007, it was reasonable to describe the policy tools of a central bank mainly in terms of its ability to raise or lower interest rates. But when the central bank starts looking at the total amount of bank credit being extended or at stress-testing whether financial institutions are well-positioned to be resilient in the face of an shock, these sorts of goals can also be accomplished by so-called "macroprudential regulation," which involves adjusting credit conditions by adjusting the rules and standards to be applied by financial regulators.